UNIT-V

Investment Spending and Demand and Supply of Money

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 LESSON: 1 UNIT-V

Investment Spending and Demand and Supply of Money

1. STRUCTURE

1.1 Objective
1.2 Introduction
1.3 Concept of Investment Spending
1.4 Theories of Money Demand
1.5 Supply of Money
1.6 Summary
1.7 Self Assessment Questions
1.8 Suggested Readings

1.1 OBJECTIVE

After reading this lesson, you should be able to:

a) Differentiate between different types of investment spending.

b) Determine demand of money using different theories.
c) Determination of money supply.
d) Analyze how money supply is created by banks
e) Examine the relation between various monetary policies and its impact on
money supply

1.2 INTRODUCTION

The equilibrium in macro economics is when aggregate demand and aggregate supply
are equal and aggregate demand in a macro economics consists of consumption by
households, investment by the firms, expenditure by government and net exports. The
previous chapters have talked about consumption, government expenditure and net
exports and investment was assumed to be autonomous in all the previous chapters.
This chapter discusses about different forms of investment and factors on which
investment depends. Equilibrium in the money market is when money demand and
money supply are equal. To explain the concept of money demand it explains various
theories that help in determining the demand of money. It also explains how banks
help in creation of money through credit creation process and various monetary
policies of the central bank that have an impact on the money supply.

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1.3 CONCEPT OF INVESTMENT SPENDING

Expenditures made by the business sector on final goods and services, or gross
domestic product, especially the purchase of productive capital goods. It can be
broadly divided into three types:

Business Fixed Investment: It is the most common form of investment that includes
expenditure by firms on the fixed investment that is capital goods like machinery,
equipments, building for factory etc. It is one of the main contributors to economic
growth and one of the most crucial decisions that have to be undertaken. While
deciding about whether to go ahead with a particular investment or not firms use
discounted techniques which is because of the fact that the revenues take place in the
future whereas costs are usually incurred in the present, to calculate the viability the
future stream of revenue has to be discounted to get its present value. These decisions
are very crucial because of the fact the once started it is very difficult to reverse them
without incurring any costs.

Residential Investment: It includes expenditures on houses, buildings, and similar

types of shelter. Residential fixed investment includes structures built, owned, and
occupied by individuals and it also includes residential places developed by
businessman whose business is to sell or give on rent such property. To decide
whether to go for this type of investment or not the benefits and costs associated with
it has to be seen. Benefits include the imputed rent if the house is being used for self
accommodation or earned rent if it has been rented out and the capital gain (or loss)
because of change in the value of the investment. Cost includes the interest payments
if investment has been taken on loan and depreciation or annual expenditure on
maintenance. If benefits outweigh the cost the investment should be done otherwise it
should not be.

Inventory Investment: Firms not only invest in fixed assets but also in raw materials,
work in progress and finished goods that are kept in the stock in anticipation of to be
sold in the future. Firms usually keep a ratio of inventory to the sales to ensure they
do not lose out any opportunity in the market. Although inventories are a relatively
small portion of the overall investment sector, inventories are a critical component of
changes in GDP over the business cycle. If the economy is slowing down then
inventories and that too unexpected inventory would pile up and if there is boom in
the economy then inventories would come down. Thus changes in the inventory
determine the production level of the firm whether it needs to increase the production
or reduce it.

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1.4 THEORIES OF MONEY DEMAND

Money demand and money supply needs to be understood to establish the money
market equilibrium. Money demand refers to demand for real money that is demand
of money for transactionary purposes. People hold money with them because they
need to enter into transactions and for that liquidity is needed. Demand of money for
transactionary purpose is directly related to income level and inversely related to real
rate of interest. This is the simplest theory of money demand as was also done in LM
or money market equilibrium. Other motive for holding money is for precautionary
motive and speculative motive.

Tobins Portfolio Theory: Portfolio refers to a mix or combination of different

assets that people hold in with them to satisfy their requirements. The different
proportions of assets that individuals hold depends on the risk and return of different
assets and the total wealth that they have. So the demand function can be written as:

(M/P)d = f(rs, rb, e, W)

Where (M/P)d refers to real demand of money for transactionary purpose.

rs = Expected real return on stocks

rb = Expected real return on stocks

e = Expected Inflation rate

W = Real Wealth
An increase in real return on stocks or bonds reduces the demand for real money as
the opportunity cost of holding money increases and stocks and bonds become more
attractive. an increase in expected inflation also reduces demand of real money. An
increase in wealth however increases the demand of real money. Thus this theory
emphasize that demand function of money should include expected returns on other
assets too. However the theory is applicable only if M2 measure of money is
considered and fails if M1 is taken into consideration. There is another theory by
Tobin which takes into consideration behaviour of individual wealth holder and
assumes only two components to be a part of the portfolio - money and bonds. The
expected proportion of money and bond that an individual would hold depends on
expected gain and expected risk of the portfolio. Earlier theory ignored the
determination of the transactions demand for money and considered only the demand
for money as a store of wealth. Here the focus is on an individuals portfolio
allocation between money-holding and bondholding, subject to the wealth constraint.
The theory is based on certain assumptions like:

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1. Wealth is considered as an economic good and risk is an economic bad

2. In case of money there is no return or risk.

3. The expected capital gain on bonds is zero. This is because the individual investor
expects capital gains and losses to be equally likely.

4. Bonds pay an expected return of interest, but they are a risky asset. Their actual
return is uncertain due to the fact that the market rate of interest fluctuates even in the
short run.

The theory can be explained using the following figure:

Figure 1: Tobins Portfolio Theory

Here W is the initial wealth that the individual has which has to be divided between
money and bonds. If the individual holds the entire wealth in form of money then
after a year his wealth would be the same as money earns neither any return nor any
risk. However if the investor invests entire wealth in the bond with an expected real
interest rate of r% the wealth after a year would be w(1+r) and the risk as measured
by standard deviation is max shown by R1. But the portfolio that investor chooses
depends upon the point of tangency between indifference curve and the budget
constraint where the highest possible indifference curve is tangent to the budget
constraint it is the equilibrium showing the proportion of wealth between money and
bonds. The shape of the indifference curve is such that because on x axis there is an
economic bad and on y axis there is economic good. If there is change in the interest
rate the budget constraint would change and the portfolio of the investor would also

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change depending upon whether the investor is risk averse, risk neuter or risk lover. It
can be shown as follows:

Figure 2: Tobins Portfolio Theory: Risk Neuter Investor

A risk neuter is one who is indifferent towards risk and is only concerned about
return, so with increase in the rate of interest the risk neuter brings no change in the
proportion as he gets more return now with the same portfolio because of increase in
the rate of interest.

Figure 3: Tobins Portfolio Theory: Risk Lover Investor

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A risk lover is one who seeks risk and is willing to take more risk. Thus with an
increase in the rate of interest on bonds the risk lover increases his holding of bonds
such that both the risk and return increases and the investor is satisfied because of
higher risk. Thus he moves to a higher indifference curve which is to the right
showing greater proportion of bonds as compared to previous portfolio.

Figure 4: Tobins Portfolio Theory: Risk Averse Investor

A risk averse investor is one who prefers less risk and tries to avoid risk. Thus with an
increase in rate of interest as he can earn the same wealth by investing less in bonds,
so a risk averse investor reduces the proportion of bonds in his portfolio to reduce the
overall risk and to keep the return constant. Thus there is a leftward shift in the
indifference curve. Though he is on a higher indifference curve because of increased
satisfaction due to reduced risk his return is the same as earlier.

Baumol-Tobin Model of Cash Management: This theory focuses on the

transactionary function of money as people hold money worth them because they
need to enter into transactions and to maintain liquidity cash is needed. The amount of
money that people will hold with them depends on the cost associated with holding
money which involves the interest foregone on the money being held with the
individual. The benefit includes the convenience as there is no need of going to banks
to acquire money for entering into transactions. Thus taking into consideration the
cost and benefit involved the investor has to decide the optimum sum that he needs to
hold with them such that the cost is minimum. Let us assume that investor requires
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Y sum of money to enter into transactions for the whole year and he withdraws this
at the beginning of the year and then uses it and by the year end it becomes zero. Thus
it can be presented diagrammatically as:

Figure 5: One trip to Bank

The figure shows that in the beginning of the year itself individual withdraws Y
amount of money that is needed for the transaction in the whole year. This money is
then spent evenly throughout the year such that by the year end it becomes zero. So
the average holding throughout the year is Y/2 that is opening + closing balance
divided by 2. Now if we assume that investor makes two trips to bank then the above
figure would change as:

Figure 6: Two trips to Bank

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The figure shows that in the beginning of the year itself individual withdraws Y/2
amount of money that is half the amount needed for the transaction in the whole year.
This money is then spent evenly throughout the half year such that by the end of six
months it becomes zero and then again he makes a visit to the bank and withdraws
Y/2 such that by the year end it again becomes zero. So the average holding
throughout the year is Y/4 that is opening + closing balance divided by 2.

The above figure can be expanded to show what will happen if he makes N trips to
bank.

Figure 7: N trips to Bank

The figure shows that in the beginning of the year itself individual withdraws Y/N
amount of money that is one by Nth of the amount needed for the transaction in the
whole year. This money is then spent evenly throughout the 1 by Nth of the year such
that by the end of it, it becomes zero and then again he makes a visit to the bank and
withdraws Y/N such that by the period end it again becomes zero. This process
continues for the whole year such that by the year end it is again zero and the
transactionary need of the whole period has been met by making N trips to the bank.
So the average holding throughout the year is Y/2N that is opening + closing
balance divided by 2.

Now to decide how many trips to make to bank we need to use the following
derivation:

To minimize cost to the banks we have to do the following derivation:

Total cost = Interest foregone + Costs of trips to bank

TC = iY/2N + FN where i is the rate of interest and F is the cost of per trip to bank.

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dC/dN = -iY/2N2 + F = 0 , N = iY/2F

Average cash holding is directly related to the income level (Y) and (F) but indirectly
related interest rate (i) If F is greater or Y is the greater or i is lower (where Y is the
expenditure), then the individual holds more money, that is, demand for money
depends positively on expenditure (Y) and negatively on the interest rate.

Figure 8: Minimum cost at optimal number of trips

Failure of the Model:

1. The Model failed because some people have less discretion over their money
holdings than the model assumes

2. Empirical studies of money demand find that the income elasticity of money
demand is greater than half and the interest elasticity of money demand is less than
half. Thus, the model is not completely correct.

1.5 SUPPLY OF MONEY

Credit creation which is the most important function of banks refers to the power of
the banks to expand or contract demand deposits through the process of more loans,
advances and investments. It is based on certain assumptions like all the receipts and
payments in the economy are done through the banking system and all the deposits

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that are made in the banks are not given out as loan but a part of it is reserved with the
banks in the form of legal reserve ratio and the rest is lent out. Let us take an example
that there is LRR requirement of 20% and bank receives initial deposit of Rs 1000 so
banks keep Rs 200 with them and give away Rs 800 as loan. Now the bank that
receives this Rs 800 would keep Rs 160 with them as reserve and give away Rs 640
as loan. This process would continue till money supply of 1/0.20 * 1000 that is Rs
5000 is created with just an initial money supply of Rs 1000. Thus how much money
is created is inversely related to the legal reserve ratio. the above process can also be
shown as:

Balance Sheet of Bank "1"

Liabilities Amount Assets Amount

A's deposits 1000 Cash Reserve 200
Loan to "B" 800

Total 1000 Total 1000

Now suppose that money that borrowed from bank "1" is paid to individual "C" in
settlement of his past debts. The individual "C" deposits the money in his bank say,
bank 2. Now bank 2 carries out its banking transaction. It keeps a cash reserve to the
extend of 20%, that is Rs. 160 and lend Rs. 640 to a borrower D. at the end of the process
the balance sheet of Bank 2 would look like:-

Balance Sheet of Bank "2"

Liabilities Amount Assets Amount

B's deposits 800 Cash Reserve 160
Loan to "C" 640

Total 800 Total 800

The amount advanced to D will return ultimately to the banking system, as described
in case of B and the process of deposits and credit creation will continue until the
reserve with the banks is reduced to zero. The final picture that would emerge at the
end of the process of deposit & credit creation by the banking system is presented in
the consolidated balance sheet of all banks are as under:

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The combined Balance sheet of Banks

Bank Liabilities Assets Credits Reserve Total Assets

Deposits
Bank 1 1000 800 200 800
Bank 2 800 640 160 640
Bank 3 640 512 128 512
- - - - -
- - - - -
Bank n 00 00 00 00
Total 5000 4000 1000 4000

It can be seen from the combined balance sheet that a primary deposits of Rs. 1000 in
a bank 1 leads to the creation of the total deposit of Rs. 5,000. The combined balance
sheet also shows that the banks have created a total credit of Rs. 4,000. And maintained
a total cash reserve of Rs.1000.Which equals the primary deposits. The total deposit
created by the commercial banks constitutes the money supply by the banks.

There are various instruments through which the central bank can control the money
supply in an economy like open market operations where the central bank buys and/or
sells the government securities in the open market to reduce or increase the money
supply in the economy, reserve requirements that is cash reserve ratio that is the
proportion of net demand and time liabilities that banks are required to keep with the
central bank or statutory liquidity ratio that refers to the proportion of net demand and
time liabilities that banks are required to buy the government securities, discount rate
that is the rate of interest charged by the central bank to the banks on the loans being
made. There are other measures also like moral suasion and selective credit controls
that also helps in determining the money supply in the economy.

1.6 SUMMARY

In macro economics equilibrium is when aggregate demand and aggregate supply are
equal. Aggregate demand consists of expenditure by households in the form of
consumption which is a function of disposable income, expenditure by private firms
in the form of investment, by government in the form of receipt of taxes, expenditure
on transfer payments and government purchases and external sectors exports and
imports. This chapter talks about investment expenditure which can be broadly
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divided into residential fixed investment, business fixed investment and inventory
investment. Various theories have been given that explain the demand and supply of
money like Tobins portfolio theory which determines how an individual forms his
portfolio and determine the proportion of different assets to hold. Similarly Baumol
explained how much money an investor would hold which depends on the
transactionary need of the investor and a comparison between the holding cost and
carrying cost. Similarly money supply is determined by the central bank and it takes
various policies that is quantitative and qualitative to alter the money supply as and
when required. The most important function of the banks that leads to money supply
in the economy is the process of credit creation through which money supply is
created in the economy. This process in turn depends on the legal reserve requirement
that is mandatory for the banks to hold and is a combination of cash reserve ratio and
statutory liquidity ratio in our country. Thus in this manner equilibrium is attained in
the money market when money demand and money supply become equal.

1.7 SELF ASSESSMENT QUESTIONS

Exercise 1: True and False

(a) Demand of money means demand for transactionary purpose.

(b) Risk is measured by standard deviation in Tobins Portfolio.

(c) Tobins theory is successful in case of M1 measure but not M2.

(d) Credit creation by banks is dependent on the legal reserve requirement of banks.

(e) High powered money includes cash and reserves.

Ans. 1(T), 2(T), 3(F), 4(T), 5(T)

Exercise 2: Fill in the Blanks

(a) Demand of money means demand for _ _ _ _ _ _ _ _ _ .

(b) Bonds have expected return which is equal to zero because _ _ _ _ _ _ .

(c) Exchange rate is the rate at which currency of one country is exchanged for
currency of _ _ _ _ _ _ _ _ country .

(d) Monetary policy includes _ _ _ _ _ _ and _ _ _ _ _ _ _ measures.

Ans 1. Transactionary, speculative and precautionary motive 2. Expected gains and

losses are equal 3. Another 4. Qualitative and quantitative

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Exercise 3: Questions

1. Differentiate between Tobin and Baumols theory

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2. What is the process of credit creation by banks.

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3. Explain the concept of money multiplier.

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4. How does central bank affects money supply in the economy.

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5. Explain qualitative measures of monetary policy.
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6. Explain the concept of floating and fixed rate system
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7. Explain the various components of investment.
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8. Derive aggregate demand curve in a small open economy.
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1.8 SUGGESTED READINGS

Mankiw, N. Gregory, Macro Economics, Macmillan Worth Publishers New York,

Hampshire U.K..

Dornbusch, Rudiger and Stanley, Fischer, Macro Economics Theory, McGraw-Hill

Barro Robert J., Macroeconomics Theory and Applications, MIT Press.

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